Custodial Accounts
Established in some states under the Uniform Gifts to Minors Act (UGMA), and in others at the Uniform Transfers to Minors Act (UTMA), parents or guardians are allowed to establish custodial accounts. These are simple trust accounts opened for someone under 21 years of age and controlled by the custodian, usually one of the account holder's parents, until the child reaches adulthood.
A deposit into a child's custodial account is considered a gift to your child; however, you, as the custodian, are responsible for managing the account assets until your child reaches age 18 or 21, depending on the state you live in. Currently, you are allowed to gift $12,000 tax-free per year.
When your child reaches the relevant age, she owns the account, and you will no longer have legal control over how she chooses to spend the money you intended for college. Once gifted, the money cannot be reclaimed, even if you find yourself in dire financial straits.
Fact
A child under age 14 will earn tax-free gains on the first $850 in investment income (interest, dividends, and capital gains), and pay taxes at her marginal tax rate for the next $850 of investment income. Any investment income in her custodial account over $1,700 will be taxed at your marginal tax rate. After age 15, all gains in the account will be taxable at her tax rate.
It's best to use tax-advantaged account options like a 529 savings plan to fund your child's college expenses rather than a custodial account for three reasons:
If your child has a custodial account, the account will reduce her available federal financial aid by 3.5 times (in 2007) more than the amount that it would be reduced if she had the same amount of funds in a 529 plan. One way to avoid this penalty under current law is to transfer custodial account assets required for college to a 529 savings account before your child applies for financial aid.
Custodial accounts owe taxes on all realized gains; 529 account earnings are not taxed.
No matter your child's age, you maintain control of 529 plan assets; at age 18 or 21, your child owns the custodial account and could conceivably spend the funds on clothing, a car, a tropical vacation, or entertaining her friends, rather than on college expenses as you envisioned.
Even at age 18 or 21, children are not likely to understand the financial sacrifices you made to accumulate college funds or to spend them wisely. To avoid disappointment, it's advisable to choose plans that remain under your control.
